Pros and Cons of 401K Loans

February 1, 2023

Retirement accounts are set up to form a way through which you will save and invest money during your employment and access it once you have retired. However, 401k loans are meant for you to borrow money from your retirement account in case of any financial emergency. Tapping into your 401K loans is a viable option that many people can turn to in the event of a large and unpredictable debt. 

What is a 401k Loan?

A 401(k) is an employer-sponsored retirement savings plan through which you can make pre-tax contributions to help you get through the period of your life after you have stopped working. One way of taking out money from your retirement account before you have turned 59 ½ is through a 401(k) loan.

A 401(k) loan is basically you borrowing money from yourself. It allows you to tap into the money you have invested in your retirement account with the intent that you will pay that money back to yourself with interest. According to the rules set by the IRS, the time allotted to repay this loan is 5 years unless you use this money to buy your own house in which case you have a little longer to pay back.

Pros of a 401(k) Loan

At certain points in life, taking out a 401(k) loan can make sense. Here’s why:

Simple Procedure

When you apply for a loan at a bank, the most strenuous task is the complex procedure involving lengthy paperwork, loan application, and waiting to be approved. However, when you take out a 401(k) loan, you are borrowing money from yourself so you don’t need to provide an explanation for why you need the money or worry about getting approved. The procedure is pretty simple and straightforward.

Credit Score Doesn’t Matter

Getting a 401(k) loan means that you won’t have to prove your creditworthiness and hence it doesn’t matter if you have a bad credit score. Moreover, in case of failure to make repayments, your plan administrator cannot report you and the incidence won’t affect your credit report.

Lower Interest Rate

While banks tend to collect loans with higher interest rates, 401(k) loans only indulge an interest rate of about 1-2%.

Cons of a 401(k) Loan

Some financial advisers suggest against 401(k) loans due to their risks. Here’s why:

Permittance Issues

The ability to collect a 401(k) loan depends on your employer. Every company has a different plan in this regard and they may not even let you borrow money from your retirement account. 

Borrowing Limits

While banks can offer you a wider range of money to tap into, 401(k) loans are limited to a small amount such as $50,000 or 50% of the balance, whichever is less.

Opportunity Cost

Withdrawing money from your 401(k) before your retirement means that you will no longer have a mutual fund, you lose a huge chunk of personal gains that you could have taken advantage of down the lane.